Patent Challenges and Royalty Inflation

Abstract:     
Eliminating bad patents is supposed to be a good thing, and so federal law allows any interested party to challenge a patent's validity almost any time. But the law goes a step further than merely conferring broad challenge rights. It also makes them nearly impossible to contract away. Instead, federal law voids any agreement not to challenge a patent. While a contract ordinarily signifies a final resolution of all issues covered by its terms, no such peace exists in patent licensing.

This inalienability of patent challenge rights comes at a cost, a cost borne by many patent licensees and their downstream customers. Patent holders quite rationally increase the royalties licensees must pay to offset their costs if the patent is challenged: litigation costs and loss of royalties if the patent is invalidated. Licensees, it follows, might seek a lower price by agreeing not to challenge the licensed patent, but the law will not allow them to do so.

The result is royalty inflation; the policy favoring elimination of bad patents costs every licensee by providing an inalienable challenge right that might never be exercised. This cost is a tax of sorts, what this article calls the "patent challenge tax." In addition to inflated royalties, the tax causes trickle-down costs to consumers and disincentives to create and license patented technology.

This article develops an economic model that dissects the components of the patent challenge tax, examines each component's consequences, and informs the effectiveness of various strategies that might be used to reduce the tax.

Part I of this article explains the policy at the core of the model: no patent license is ever final, allowing any licensee to sue to void the license at any time. Part II introduces and explores the patent challenge tax and its role in royalty inflation, and Appendix I fully derives the model. Part III analyzes a variety of licensing signal strategies, and considers each strategy's effectiveness, legality, and practicality. The article concludes by highlighting some of the broader policy issues associated with the tax and its components.

Keywords: patent, licensing, medimmune, deadweight loss, tax

Accepted Paper Series